On June 13, 2007, the Securities and Exchange Commission ("SEC") voted on several rules relating to short selling. Most significantly, the SEC voted to repeal Rule 10a-1 under the Securities Exchange Act of 1934 (commonly known as the "tick" test) and other price restrictions and to eliminate the "grandfather" exception to Regulation SHO's requirement that fail to deliver positions be closed out within 13 days of failure. The SEC also voted to propose and to re-propose other related amendments to the short-selling rules. Rule 105 of Regulation M — governing short selling within five days of pricing of a public offering — was scheduled to be addressed by the SEC at its meeting but was deferred to the next meeting.
A. Repealing the "Tick" Test and Other Price Tests
Sixty-nine years after its adoption, the "tick" test is about to become history.
The SEC voted to adopt amendments to Rule 10a-1 and Regulation SHO to eliminate any price test that prohibits short selling in a "down" market. The "tick" test allows short sales of exchange listed securities only when the price is not falling. Under existing regulation, short sales generally may only be made at a "plus tick" — a price above the price at which the immediately preceding sale was effected — or at a "zero-plus tick" — the last sale price if it is higher than the last different price. The NASD and the NASDAQ have their own price restrictions, called "bid" tests, which provide that short sales cannot be made at prices below the stock's best published bid price when that bid price is below the previous different best published bid price.
In 2004, the SEC ordered a pilot study for certain specified markets and securities suspending the tick test and any other short sale price test so that the SEC could study how short sale price tests affect the markets. The data resulting from this study was analyzed by the SEC's Office of Economic Analysis as well as independent economists. The SEC also sponsored a roundtable on Sept. 25, 2006, to address the data from the pilot study. The overall conclusion from the pilot study was that price test restrictions reduce liquidity and are not necessary to prevent manipulation.
The SEC voted unanimously to repeal Rule 10a-1 and to prohibit any self-regulatory organization ("SRO") from having a price test. Potential benefits to market participants from the elimination of price restrictions may be increased liquidity and more pricing efficiency. Compliance costs also may decrease, as the technology and human capital necessary to ensure compliance with the price restrictions are no longer needed. There also will be regulatory consistency on the issue between the SEC and the SROs. The amendments eliminating the "tick" test and other price restrictions will be effective immediately upon publication of the release in the Federal Register.
B. Regulation SHO Close-Out Requirement
The SEC also continued to tighten the noose on "naked shorting" practices in the market. Regulation SHO seeks to reduce the frequency of "fail to deliver" positions. The Regulation requires, among other things, that broker-dealers "close out" short positions (i.e., purchase securities of like kind and quantity) in threshold securities (which are securities that experience designated levels of failure to deliver) if that broker-dealer has a fail-to-deliver position in a threshold security for 13 consecutive settlement days. During its open meeting on June 13, 2007, the SEC acknowledged that the number of fail to deliver positions has declined substantially since Regulation SHO was adopted, but noted that further improvement was necessary.
1. Amendments Adopted to Eliminate Grandfather Exception and to Change Close-Out Requirements for Rule 144 Securities
When Regulation SHO was adopted in 2004, it contained a "grandfather" exception (Rule 203(b)(3)(i)) that does not apply the close-out requirement to positions established prior to the security becoming a listed threshold security or becoming subject to Regulation SHO. These situations were "grandfathered" because the SEC was concerned about the impact of Regulation SHO on large pre-existing fail-to-deliver positions. On June 13, 2007, the SEC voted to eliminate Rule 203(b)(3)(i), meaning that all fail-to-deliver positions in threshold securities will have to be closed out within 13 consecutive settlement days, regardless of whether any of those days occurred before the security became a threshold security. To alleviate the immediate impact of this amendment on pre-existing failure positions, for previously excepted fail-to-deliver positions that are listed threshold securities on the effective date of the amendment, the SEC will permit such positions to be closed out within 35 settlement days of the amendment's effective date.
In addition, the SEC extended the close-out requirement from 13 days to 35 days for fail-to-deliver positions resulting from sales of threshold securities pursuant to Rule 144 under the Securities Act of 1933.
The amendments modifying the close-out requirements of Regulation SHO will become effective 60 days after publication of the amendments in the Federal Register.
2. Amendments Re-Proposed to Eliminate Option Market Maker Exception
The SEC did not vote on separate amendments to eliminate the options market maker exception to Regulations SHO's close-out requirement. Rather, the Commission voted to re-propose the amendments and to solicit comment on two alternatives to elimination of the options market maker exception. As with the grandfather exception, the SEC proposed a one-time extended 35-day close-out period for previously excepted positions. The SEC also proposed amendments to Rule 200 of Regulation SHO, which would require broker-dealers marking a sale as "long" to document the location of securities to be sold. The comment period for these proposals will end 30 days from the date of publication of the proposed rules in the Federal Register.